Correction to This Article
An earlier version of this column incorrectly stated how much the owner of a hypothetical office building would be able to borrow under current market conditions. The amount would be $40 million, not $50 million, based on the parameters of the example. This version has been corrected.

Commercial Credit Crunch Means We May Not Be Out of This Yet

By Steven Pearlstein
Friday, August 21, 2009

You've probably heard that the nation's financial system is out of the intensive care unit but still requires enough support that it's not ready to be released from the hospital. A big reason: the fear of a relapse caused by the collapse of the commercial real estate market.

To understand the problem, think back to the height of the credit bubble in 2007, when $230 billion worth of office buildings, hotels and shopping centers were financed through the magic of securitization -- that process in which loans were assembled into packages and sold off in pieces to investors.

Back then, the loans originated by banks and investment houses would typically be made at 80 percent of the market value of a property, at rates as low as 1.5 percentage points over the Treasury's 10-year borrowing rate. There was often a second mortgage, known as a mezzanine loan, to cover an additional 10 percent of the original purchase price. And to make things even easier, many of the loans were interest-only, on the theory that commercial property values could only go up.

Now, of course, the credit bubble has burst. Commercial property values have fallen an average of 35 percent, with further declines expected as the recession drives more tenants out of business or puts them behind in their rent payments. The process of securitizing new loans has ground to a complete halt, and the limited financing that's available now comes from banks and insurance companies on much tougher terms. Loans now are typically for no more than 60 percent of a property's current value, with an interest rate four percentage points above the Treasury rate. Borrowers must also repay principal, which is like adding another two percentage points to an interest-only loan.

All of this has been wrenching for the industry -- particularly for some of the biggest names, such as General Growth Properties, Maguire Properties and Tishman Speyer, which bought at the top of the market. Not only has their equity been pretty much wiped out, but those who financed their bubble purchases have lost anywhere from 35 cents to 100 cents on every dollar lent.

Unfortunately, this isn't just a tragedy for rich developers, bankers and investors. It's also a problem for the rest of us.

For starters, local and regional banks have so many souring commercial real estate loans that they have begun to fail at a rate not seen since . . . well, you know. The latest was Colonial Bank of Alabama, which was rescued last week at a cost to the Federal Deposit Insurance Corp. of about $2.8 billion, the sixth-largest bank failure in history. And over the coming year, it will be a rare Friday afternoon that the FDIC doesn't announce the takeover of some bank that lent too much to local builders and commercial real estate developers despite abundant evidence that a bubble had developed. It's a good bet the agency will have to replenish its coffers by drawing on its line of credit from the U.S. Treasury.

Then there's the matter of half a trillion dollars in securitized loans that were made during the bubble and will be coming due over the next few years. These will need to be refinanced. Unless the securitization machine can be cranked up again, there's simply not enough lending capacity at the banks and insurance companies to fill the gap. Moreover, there can be no refinancing until the current owners of the buildings come up with billions of dollars in fresh equity to make up for what has already been lost.

Consider the example of a hypothetical office building bought for $100 million back in the go-go days, with 90 percent of the purchase financed with borrowed money. Now, suddenly the loan needs to be refinanced, but the value of the property has fallen to $65 million. In the new conservative environment, the owner can only get a new loan for $40 million, which means that in order to avoid foreclosure and keep ownership of the building, he has to come up with an additional $50 million in equity. Given that the value of the building would have to hit $90 million before anyone would realize a dime in profit, investors probably won't be lining up for that opportunity.

So how does all this get resolved?

In the case of buildings that still generate rents sufficient to pay the monthly interest charges, the lenders -- that is the holders of the mortgage-backed securities -- will probably agree to extend the loan for a few years in the hope that property values quickly rebound and the market for securitized loans revives. "Amend, extend and pretend," as my friend Arthur, the real estate maven, put it.

In the case of projects with rising vacancies and falling rents, however, the more likely scenario is that the lenders would foreclose on the property and sell it for whatever they can get. The problem is that if too many buildings are dumped on the market at the same time, it would trigger a self-reinforcing downward cycle that could depress property values even further, leading to more foreclosures and causing even more banks to fail. That's what happened back in the savings and loan crisis.

This is why commercial real estate is now a top priority for policymakers in Washington. Earlier this week, the Treasury and the Federal Reserve quietly extended until next June their program to offer low-cost loans to banks, hedge funds and other investors willing to purchase mortgage-backed securities. While $3 billion has now been lent for the purchase of securities issued before the crisis, there's been no lending for newly issued securities, because no new securities have been issued. Government and industry officials say this reflects a continuing distrust of the securitization process and widespread concern among investors that property values still have further to fall. They also cite the difficulty in finding the additional equity capital necessary to make refinancing possible.